Hurricane Sandy's Opportunity Costs

As occurs every time there is a natural or manmade disaster, the media focus almost exclusively on the economic stimulative effects of the consumption and investment necessary to repair and rebuild in pursuit of recovery and a return to what was.

The point is that money is now being consumed to get back to break even. In purely economic terms, costs are being absorbed by the economy, the business sector and society, for which there is no multiplier, no gain.

There are two kinds of costs associated with such recovery: the known and the unknown.

The known costs and the sectors of the financial markets and economy that will benefit from the costs of recovery are easier to anticipate. After the stock market's two-day closure, Home Depot (HD) and Lowe's (LOW) both gapped up on Wednesday's opening as traders and investors began to anticipate that those stocks would benefit from the requisite costs of repair. The same was true of Caterpillar (CAT), 3M (MMM) and a swath of other companies associated with the construction industry.

The unknown costs are less identifiable, because they represent lost opportunity costs, consumption and investment that would have occurred if Hurricane Sandy hadn't caused funds to be diverted to recovery expenses.

In short, the broken-window fallacy stipulates that the cost of such repair is incurred to return to status quo and that the capital consumed in doing so has precluded the consumption of something else instead. The homeowner who now must buy new furniture, carpeting, roofing, etc., must forgo something else, perhaps a new car or a vacation.

But because we don't know what has been forgone, traders and investors can't tell what stocks will be negatively affected by this activity. This effect is, however, no less real than the incurred costs that benefit the recovery companies.

Even the insurance companies did not incur a decline in their stock prices, as the costs they will incur are anticipated to be less than what they had reserved and purchased re-insurance for.

This leads many to believe that there is a net aggregate gain in such crises for both the economy and for the financial markets -- the proverbial free lunch. Although it is possible that if such a crisis were to occur while economic activity was deeply depressed, the forced consumption mandated by recovery could become the catalyst for an increase in secular economic activity, that is not the case now.

The bottom line is that the capital being expended to the benefit of the companies best positioned to meet recovery needs is being diverted away from the rest of the economy and businesses.

The net cost of Sandy appears to be about equal to a single day's worth of GDP, at about $50 billion, with half being incurred for recovery and half being incurred in lost production.

Although the property damage so far is estimated to be about a quarter of what was caused by Hurricane Katrina in 2005, it's appropriate to note the comparisons to stock prices of recovery companies after the event.

A year after Katrina struck, Home Depot and Lowe's were trading 10%-15% below what they were trading at when Katrina struck. Caterpillar and 3M were both sideways a year later. And this occurred at the height of the real estate bubble.

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